Buffett’s Big Bet Comes at a Hefty Price for Bank of America

Berkshire Hathaways investment of $5 billion in Bank of America comes with a costly price tag for a bank that has a host of real estate problems, as did Berkshires $5 billion investment in Goldman Sachs (GS) at the height of the financial crisis (even though Berkshires warrants in this deal would create losses for Buffetts company if exercised today).

The way the Bank of America deal is structured, Warren Buffetts Berkshire will get 50,000 preferred shares in a private offering that carries a sweet dividend of 6% a year; Bank of America can buy those shares back at any time by paying Berkshire a 5% premium.

Along with that, Berkshire gets warrants to buy 700 million shares in Bank of America at an exercise price of $7.14 each. The warrants may be exercised in whole or in part over a very long 10 years, following the close of the deal.

The shares are moving higher on the news, and Berkshire had a $546 million paper profit based on BofAs share price of $7.92 by late morning. Fully exercised, the warrants would give Berkshire an estimated 7% stake in the company.

A 6% dividend is a high price to pay, and along with the 5% premium, is expensive capital on any measure. The deal is a red flag that Bank of America is struggling through a portfolio of mortgage, home equity, and commercial real estate loans it is having difficulty getting out from under.

The Bank of America deal is similar to a $5 billion investment Berkshire made in Goldman in September 2008, at the height of the financial crisis. Goldman paid a rich 10% dividend, or interest, on those preferreds to Berkshire. Goldman had to get Federal Reserve approval to buy back Berkshires $5 billion in preferreds this past March, and it did so by also paying a $500 million fee.

Berkshire still owns warrants in the investment bank that expire in October 2013, which lets it buy $5 billion in New York-based Goldman Sachss common stock at $115 a share, or 43.5 million shares.

But those warrants hinge on Goldmans success story, which hasnt looked so hot lately given probes by the Justice Department that it misled Congress and investors on its asset-backed securities deals.

If those warrants were fully exercised today, they would give Berkshire a 12% ownership stake in Goldman Sachs but Berkshire would be exercising them at a loss.

At their peak in October 2009, when Goldman shares were trading at $192, those warrants had a paper value of $3.4 billion, says FOX Business senior editor Charles Brady. But today Goldman shares are changing hands at a far lower price of $110. Since thats less than the $115 exercise price on the Goldman warrants, those warrants are currently under water by about $200 million.

Earlier this month, Bank of America chief executive Brian Moynihan told investors and analysts on an August 10 conference call that the bank could conduct asset sales to add to its capital. The call came two days after shares plunged by 20% on news that American International Group (AIG) had slapped it with a $10 billion lawsuit alleging the bank committed securities fraud.

Bank of America is the countrys largest bank by assets, just edging out JPMorgan Chase (JPM). It just reported an $8.8 billion quarterly loss, its biggest ever.

Bank of America sorely needed Berkshires vote of confidence, because, given its valuation, the stock market is not trusting Bank of Americas balance sheet.

After news of Berkshires $5 billion cash investment, the banks market capitalization rose to $70.8 billion. Thats still lower than its market valuation as of late June, when it was $99.8 billion. And that market cap is a surprisingly slim 34% of the company's $205.6 billion book value, or common shareholder equity, what it could have on hand via quick sales it could conduct to give back to shareholders if the bank had to be broken up, according to its filings with the Securities & Exchange Commission.

Also, its $70.8 billion market cap is less than its $71 billion in goodwill. Goodwill is a line item that generally represents the excess amount a company pays to buy other companies, or whats called a premium, in this case acquisitions such as Countrywide Financial and Merrill Lynch.

Another measure of its tangible book value, a measure that shows its book value on a hard assets basis, which also is its cushion to absorb pending losses, is just $125.4 billion, according to its SEC filings. Thats just $54.6 billion more than its market cap of $70.8 billion.

BofA is also struggling to pay an $8.5 billion lawsuit brought against it by 22 investors including the New York Federal Reserve, Black Rock and Pimco, among others, over $56 billion in rotten mortgage-backed securities they bought.

Bank of America and Countrywide sold approximately $1.1 trillion of loans originated from 2004 through 2008 to Fannie Mae and Freddie Mac, according to its SEC filings

It has also been hit with $27.7 billion in repurchase claims from these mortgage finance companies to buy back defective loans, according to its SEC filings.

BofAs latest SEC filings show it bought back $22 billion worth of these defective mortgages that it had sold to Fannie and Freddie, more than five times the $4 billion it told investors it would buy back last fall.

BofA will also have to foot part of the bill for the foreclosure settlement deal in the works with the 50 state attorneys general; the total settlement amount here has swung from as low as $7 billion to as high as $22 billion.

BofA has already written off multiple times over its $2.5 billion acquisition of Countrywide Financial, one of the worst corporate mergers in U.S. history, (the final deal sum reached in July of 2008 was 37% less than the initial $4 billion price agreed upon as of January 2008, as foreclosures rose and both banks share prices fell).

As for its exposure to problems in the Eurozone, Bank of America says in its latest SEC filings that it has $20 billion in exposure to France alone.

It also says it has an average $303.4 billion in commercial real estate loans and lease exposure, and an average $131.8 billion in home equity loans. Many of these loans are problematic.